One of the positives with regards to all this ’junk’ talk is one can see it becoming more and more of a dinner table conversation, as the potential impact will hurt everyone. Some of those conversations may not be fruitful but it’s a step in the right direction that there’s a better understanding of what it all means. And while the cons of such a move are prevalent, Investec’s Nazmeera Moola, unpacks the myths of ‘junk’. It’s an interesting read that might have you sleeping a little easier at night, as this and other important movements within government and business, offer some relief. – Stuart Lowman
By Nazmeera Moola*
After the events of mid-December last year (now euphemistically termed #Nenegate), many investors – both within the country and those from foreign ranks – are justifiably concerned about the fate of South Africa. The most prominent question seems to be on whether we will lose our sovereign bonds’ investment-grade credit rating and downgraded to so-called junk debt.
The myths of junk
While undoubtedly serious, the threat of a downgrade to sub-investment grade needs to be seen in context. Firstly, South Africa is on the cusp of losing its investment grade rating with one of the three major ratings agencies – Standard & Poor’s – who has rated the country at BBB- with a negative outlook. It has two years in which to decide if it will lower the credit rating to BB+ or if it will remove the negative outlook and keep South Africa at BBB-. So, this rating could remain at BBB- for up to two years.
Secondly, the potential downgrade to junk status only applies to the sovereign debt issued in foreign currency, which is approximately only 10% of the country’s total issued debt. The vast majority of South Africa’s debt has been issued in local currency. It is also these rand-denominated bonds that have been included in the World Government Bond Index (WGBI). Therefore, if the country loses its investment grade rating, it will not force widespread selling from rand-denominated South African government debt.
No longer the ‘least ugly girl at the ball’
Though South Africa is not peering over the precipice just yet, all is still far from well with South Africa’s finances. In the immediate aftermath of the finance minister shuffle, investors were clearly rattled, judging by the sharp weakening of the rand and the sell-off in bonds. Even now, with an experienced and trusted hand back at the helm of the Treasury, the rand is still significantly weaker than it traded at the beginning of December, and bond yields are still 80 basis points higher than before President Zuma’s announcement.
This is partially due to a deterioration in the global economic environment. But we believe it is mainly the result of a loss of trust in the Treasury and South African Reserve Bank. This trust has been built up with investors over the last 20 years.
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This meant that, despite global developments, emerging market issues and indeed our own challenges (such as Eskom concerns, disappointing growth etc.) South Africa was still viewed as the ‘least ugly girl at the ball’. I.e., investors would be cognisant of risks pertaining to emerging markets and South Africa, but were reassured by the belief that the country has strong structural institutions in the Treasury and SARB, which would largely do the right thing.
By his announcements in December, President Zuma managed to undo this trust in one quick move. It will take a long time to rebuild it. Prior to the president’s announcement the R186 was trading at 880 basis points, whereas it is now in the region of 930-960 basis points.
Where to now?
Despite the worrying situation, all is not lost for South Africa’s finances. Since his re-appointment, finance minister Pravin Gordhan repeatedly has reiterated his commitment to retaining South Africa’s investment grade rating. The first step will be the presentation of a plausible 2016 National Budget to parliament later this month. To buy time with the rating agencies, Minister Gordhan needs to produce a far smaller budget deficit for the fiscal year that starts 1 April 2016 than the 3.3% of GDP the Treasury announced in the October 2015 Medium-Term Budget Policy Statement.
Read also: S&P negative outlook: South Africa heading towards the junk cliff
The Treasury is facing lower revenues than they have previously forecast. To produce a lower deficit, he will have to raise taxes and cut expenditure. In an already weak economy, this will not be easy to achieve. Furthermore, with municipal elections looming, there will be the temptation to distribute some largesse. Unfortunately the cupboards are bare, and there is only room for symbolic largesse.
Gordhan will also have to provide continued assurance that South Africa will not incur any major long-term liabilities that are not funded. In light of recent events, there also has to be an awareness that there is zero room for populist spending such as the student fee debacle of last year.
With all this in mind, the minister’s ability to produce a great budget is limited, but ideally we should see a reasonable budget. This will buy time with the rating agencies. The key is to combine it with tangible progress on structural reforms that will boost the growth outlook. These measures should include the resolution of the visa issue, some headway on labour and education reforms, doing away with undue bureaucracy in small business and the award of independent coal power provider contracts to the private sector. If the South African government can implement structural reforms, these should go a long way towards easing the pressure on our sovereign bond ratings.
- Nazmeera Moola, Economist and Strategist, Investec Asset Management
